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Global Markets Rally Higher
Investors rejoice despite government shutdown and tapering fears
Historically, October has been one of the most volatile months for equity markets, and this year looked to be no different. The stage was set as continuing uncertainty over the prospect of the U.S. Federal Reserve slowing the pace of its bond buying program weighed on investors. Adding fuel to this potential fire was the high stakes game of chicken playing out between the Republicans and Democrats that led to a 16 day shutdown of the U.S. government and raised the possibility that the U.S. could default on its debt.
Despite these looming threats, investors shrugged them off as inconsequential as global equity and bond markets rallied higher. The S&P/TSX Composite Index gained 4.7%, the S&P 500 was up 4.6% and the MSCI EAFE Index gained 3.4%. The Canadian dollar fell from $0.9723 U.S. to $0.9589, which helped to boost the returns for Canadian investors.
Liquidity has been one of the main reasons that markets have rallied, and there was continued positive news on that front. The Fed once again held their bond buying steady, while many global central banks kept their monetary policy very accommodative. Markets also rallied on news that U.S. President Barrack Obama would name Janet Yellen as Ben Bernanke’s successor as the Chair of the U.S. Federal Reserve. Ms. Yellen has been quite dovish in her views on monetary policy, and her appointment makes it very likely that it will be at least early 2014 before there is any serious talk of tapering.
As we enter the final quarter of the year, my investment outlook favours actively managed equities over fixed income. Looking at the employment and inflation outlook, it is now looking as though it will be at least early 2014 before the Fed can begin to curtail their bond buying. While that provides the potential for a short term rally in bonds, there is still a higher probability that we will see bonds remain flat or fall over the medium to long term.
Within equities, the recent rally in European equities has left valuations looking a bit rich, giving the potential for a pullback in the near to medium term. I certainly don’t expect anything close to what we saw in 2008, but some pullback is likely. For longer term investors, any such pullback would be a good opportunity to add to your European holdings.
I am favouring North American equities over Europe or Asia. In the U.S., we are starting to see signs that corporate profit growth will slow in 2014. If growth merely moderates, valuations look reasonable and modest gains are expected. However, should growth slow significantly more than expected, a selloff is probable. Another concern in the U.S. is the uncertainty that could be created as partisan bickering gets in the way of a negotiated settlement to both the U.S. budget situation and the debt ceiling. Should another government shutdown happen in the New Year, equities are likely to be hit, further eroding investor and consumer confidence.
In Canada, I continue to favour those funds that look much different than the S&P/TSX Composite Index. These funds offer more diversified exposure to Canadian equities and as a result, are less risky, at least in my opinion. A concern with Canadian equities is the potential headwind that could result from commodity prices. With inflation on the backburner, the outlook for gold remains muted. Oil and gas look to be on an upswing, as global economic activity continues to improve. Still, I continue to focus on managing overall volatility in the current environment.
Please send your comments to feedback@paterson-associates.ca.
Funds You Asked For
This month, I highlight a handful of U.S. equity offerings and requests for gold and healthcare funds
Mawer U.S. Equity Fund (MAW 108)
Mawer is one of those fund companies that seems to do most things right. They offer a decent family of funds run by quality managers, following a disciplined repeatable process, all at a reasonable cost.
Manager Grayson Witcher took over Mawer’s U.S. offering in 2009 and really struggled to turn the fund around and differentiate this fund from the pack. Looking at his recent performance however, it certainly appears that he is making progress on that front. For the three years ending October 31, the fund gained an annualized 17.4%, matching the S&P 500 Index, but handily outperforming the majority of its peer group.
Volatility has been higher than the index and appears to be on the rise. Since the new manager took over it has been outperforming the index in up markets, but it has been underperforming when markets fall.
The investment process is very much a research driven, bottom up approach. He is looking for well managed companies that have a history of earning attractive return on capital, strong balance sheets, and a record of delivering strong operational and financial results. Valuation is a consideration, and he will try to buy names when they are trading below their estimate of its true worth. The process is very patient, with portfolio turnover averaging well below 10% for the past five years.
It is fairly diversified, holding just under 60 names with the top ten making up a third of the fund. Sector positions are capped at 20% of the fund based on book value, but recent market growth has brought the weighting of the financial to 22% of the fund. Technology is the next largest sector, coming in at 19%.
One of the biggest plusses of this fund is that the cost is very reasonable, with an MER of 1.19%
I am encouraged by the turnaround that the fund has been having. Still, I do have some concerns, namely the increased downside that the fund has been experiencing since the new manager took over.
I expect that over the long term, you will earn index like returns with slightly higher than index like volatility. Given that, I would likely lean towards the TD U.S. Index Fund over this offering. It offers lower cost, and a very comparable risk reward profile. If you want an actively managed fund, then this really isn’t a bad option.
Mackenzie Canadian Large Cap Dividend Fund (MFC 1531)
Formerly known as the Mackenzie Maxxum Dividend Fund, this dividend focused offering was renamed to the Mackenzie Canadian Large Cap Dividend Fund. This happened in the summer, as part of Mackenzie’s reorganization of its sprawling fund family.
To be considered for inclusion in the fund, a stock must have a dividend yield of at least 1%, and a market capitalization of at least $1 billion. They also must have a strong management team, be financially sound with a history of solid earnings growth. The result is a fairly diversified portfolio that holds anywhere from 45 to 65 names. Currently it is holding 60, with the top ten representing 42%.
It can invest up to 30% in foreign stocks. They are taking advantage of that option, as nearly 26% is invested abroad, with the lion’s share in the U.S.
Like other dividend type funds, it has a bit of a value tilt to the portfolio. Not surprisingly, financials and energy represent more than half of the portfolio, given their above average yields. All the big five banks are in the top ten holdings.
In a recent commentary, the managers stated that they believe that dividend yields remain attractive. It is their view that investors demand for yield and the expected rotation out of fixed income into higher yielding equities will provide an underpinning of support and allow for upside potential.
While that may be their outlook, their past performance has largely been disappointing. More often than not, it has been in the bottom half of the category.
Considering the above, this is not a fund that I would recommend. I expect that performance will be middle of the pack at best and volatility will also be about average. Factor in an MER of 2.50% and I believe that there are better choices available.
Mackenzie U.S. Large Cap Class (MFC 1022)
Recently added to my Recommended List of funds, this U.S. equity fund is a good core holding for many investors. In selecting stocks for the portfolio, the managers use a two pronged approach. One approach is a company specific approach. Here, they look for opportunities that are specific to a particular company. Examples would include a company that is going through a restructuring, changes in management, or a reallocation of capital. The other approach that is used is a more thematically driven one, that looks at the world from a top down perspective, looking to identify market sectors that can benefit from the company environment.
Regardless of which investment approach brings an investment idea to their attention, they look for companies that have strong competitive advantages that are experiencing a positive growth environment. The result is a concentrated portfolio of between 40 and 50 names. Typically, the top ten holdings will make up about 30% of the fund. The investment process is fairly active, with portfolio turnover averaging around 100% for the past five years.
Recently, the managers have been increasing the exposure to cyclicals in the fund. They believe that the U.S. is on a path to return to sustainable economic growth. Another concern is that many of the more defensive names have experienced big run-up’s and they don’t want to chase the valuation levels. Another theme they are playing is one of energy self sufficiency for the U.S. They cite that domestic oil production is at 20 year highs, and this trend will benefit many U.S. based companies.
Performance, particularly the long term numbers, have been strong. Since 2008, it has finished in the top quartile, except for 2009. Volatility has been roughly in line with the index, but the recent increase in cyclical exposure may push that higher.
Still, it is my view that this is a pretty solid option for investors looking for actively managed U.S. equity exposure. I expect that its performance will be comparable to the broader index, but with better downside protection. The costs are on the high side at 2.58%, but I do believe that fund will compensate investors for the extra cost over the long term.
RBC O’Shaughnessy U.S. Value (RBF 552)
In managing this U.S. equity fund, Jim O’Shaughnessy uses a quantitatively driven approach to stock selection. He has poured over decades of historical stock data to determine the factors which have, at least on a historic level, delivered excess returns to investors. He outlined his findings in his book “What works on Wall Street”. The key factors that are considered by the model include sufficient trading size, trading volume, growing sales and cash flows. Another metric considered is what O’Shaughnessy calls “shareholder yield” which is a combination of dividend payouts and stock repurchase programs.
Currency exposure is fully hedged. This will boost performance when the U.S. dollar is rising, and will hurt when it falls.
The fund has been on a tear of late, gaining 39% in the year ending October 31. For the past three years, it has averaged an annualized 19.5% per year, outpacing both its peer group and the S&P 500.
Historically, value investing has been less volatile than other investment styles. This fund definitely bucks that trend. Its volatility is considerably higher than the broader market. In fact, its volatility is nearly double that of the S&P 500. It is also prone to some pretty big drawdowns. Between June 2007 and February 2009 it dropped by a staggering 61.8%.
For investors who have an iron stomach and are looking for long term capital growth within the U.S. market, this may be a fund to consider.
PH&N U.S. Dividend Income (RBF 1460)
This fund invests in a relatively concentrated portfolio of U.S. based companies that have a growing dividend stream and attractive valuations. Most of the holdings are big, well know, blue chip companies like Johnson & Johnson, Chevron, Exxon Mobil and GE.
The sector mix is fairly diversified. Given the focus on dividends, it is not surprising to see that financials have the largest weighting in the fund, at about 19%. Industrials, healthcare, technology, energy and the consumer sectors are all fairly evenly represented, holding between 12% and 15% each.
While the fund may be called the PH&N U.S. Dividend Income Fund, it does not pay a regular distribution. Instead it pays out an annual distribution at year end.
Performance has been middling at best for the lower cost D Series units. For the past year, it gained 29%, which lagged both the index and the majority of its peers. Longer term, the numbers aren’t substantially better, with a five year annualized gain of 9.8%, compared to the S&P 500 which gained 11.7%. If we look at the higher cost Advisor Series units, the results are even more disappointing. The volatility has been in line with the index and category average.
Considering all the above, this isn’t a bad fund, I just don’t see any compelling reason to own it. There are better U.S. equity picks available, or you could go with an index fund for a stronger risk reward profile. That is particularly true if you are considering the higher priced advisor series units.
Dynamic Precious Metals Fund (DYN 046)
Gold and precious metals funds had a big run-up from October 2008 to later 2010, but have sold off sharply since mid 2011. This fund is no exception, dropping more than 55% in the past year.
It invests in companies involved in the exploration and production of precious metals like gold, silver and platinum. This fund is more volatile than its peers, largely because it has a greater exposure to junior and intermediate gold & precious metals companies.
The environment for gold is not particularly favourable with lower bullion prices, increased production costs, and unfavourable results from previous mergers & acquisition activity. Further, with U.S. economic growth looking as though it may moderate, and Fed tapering inevitable, the outlook for inflation remains quite muted.
In this environment, I would be hard pressed to find a good reason to overweight gold exposure in a portfolio, and I’m even having a tough time justifying having much exposure at all.
Given the volatility profile of this fund, if I were to add precious metals exposure to a portfolio, this would likely not be my choice. I would likely go with RBC Global Precious Metals or Sentry Precious Metals Growth Fund. Both of those offer what I believe to be a more favourable risk reward profile than this offering.
Renaissance Global Health Care (ATL 1161)
This used to be my favourite healthcare fund until the high fees and middle of the road performance dampened my enthusiasm.
One of the things that I have always liked about this fund is that management team has always used more of a bottom up, value focused approach to stock selection in what is typically thought of as a growth sector. Because of that, it has tended to be one of the least volatile funds in the category.
Performance, at least on a relative basis has been lackluster for the past few years. While the 3.28% MER is a contributor to that, so too is the manager’s style. The value type opportunities they favour aren’t as abundant as they once were, making it more difficult for it to generate the types of returns it had historically. It has tended to favour the larger, more established drug companies, while many of its peers had more exposure to biotech companies.
Going forward, I expect it will be much like it has been in the past – average returns, below average risk and way above average cost. I believe that the CI or TD healthcare offerings would be better than this.
If there is a fund that you would like reviewed, please email it to me at feedback@paterson-associates.ca.
November’s Top Funds
AGF Traditional Income Fund
| Fund Company | AGF Investments |
| Fund Type | Canadian Neutral Balanced |
| Rating | A |
| Style | Blend |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | Peter Frost since May 2010 Tristan Sones since May 2010 Tom Nakamura since May 2010 |
| MER | 2.24% |
| Code | AGF 4116 – Front End Units AGF 4216 – DSC Units |
| Minimum Investment | $500 |
Analysis: This balanced fund invests in a mix of stocks and bonds and has the objective of paying a regular cash flow to investors, which is currently targeting 4% per year. It is paying a variable distribution that is currently averaging around 4.4 cents per month, which works out to an annualized yield of just under 5%.
While the target asset mix is set at 50% equity and 50% fixed income, the management team has a lot of flexibility to adjust it based on their outlook. The currently favour equities, which make up 65% of the fund. Around 21% is invested in bonds with the balance in cash.
Equities are managed by Peter Frost using a disciplined process that involves top down quantitative screening and fundamental bottom up company analysis. He looks for companies that have a history of increasing dividends and generating increasing cash flows.
The fixed income sleeve is managed by Tristan Sones and Tom Nakamura. It is a mix of government and corporate bonds, and is actively managed. They have taken advantage of the recent bond market selloff to add some duration exposure to the fund. Still, it remains lower than the index.
Performance over the past three years has been strong, gaining an annualized 7.2% while the benchmark was up 4.7%. It has held up well in down markets, seeing about half the drops of the benchmark. While returns have been above average, volatility has been lower than the index.
I have been reasonably impressed with the fund. I like the managers, their process and their focus on managing risk. Costs are reasonable, with an MER of 2.24%, which is in line with the category average. For investors who are looking for a mix of income, growth and below average risk, I believe that this has the potential to be a great core balanced fund that does just that.
EdgePoint Global Portfolio
| Fund Company | EdgePoint Wealth Management |
| Fund Type | Global Equity |
| Rating | B |
| Style | Value |
| Risk Level | Medium |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | EdgePoint Investment Team since November 2008 |
| MER | 2.21% |
| Code | EDG 100 – Front End Units EDG 300 – Low Load Units |
| Minimum Investment | $15,000 |
Analysis: At EdgePoint, the investment philosophy is very simple – business people buying businesses. In managing their funds, they look to buy high quality companies that are trading at prices below their estimate of their true worth. They employ a fundamentally driven, bottom up investment process.
The portfolio is very concentrated holding 37 stocks, with the top 10 holdings making up nearly 40% of the fund. Given the investment approach, they are benchmark agnostic. As a result, the fund looks nothing like its benchmark, holding significant overweight positions in technology and healthcare. It has very little exposure to energy and materials, which is not surprising given their emphasis on sustainable free cash flow.
The fund has an all cap go anywhere mandate but at the end of August, two-thirds of the fund was in the U.S.
The managers take a long term view when analyzing a company. Portfolio turnover has been relatively modest, averaging just north of 30% since inception.
Performance since inception has been very strong. For the three years ending October 31, the fund gained an annualized 16.3% while the MSCI World Index gained 13.5%, outperforming 98% of all global equity funds.
One drawback to this fund is that it has been more volatile than the index and many other global equity funds. Given the concentrated portfolio, all cap focus, and disciplined management style, I would expect that volatility will remain higher than average.
The cost is reasonable with an MER of 2.21% for the front end version and 2.48% for the back end version.
While I like this fund, it is not a core holding for everybody. If you have a longer term time horizon and can stomach some short term underperformance in exchange for the probability of outperformance over the longer term, then this is a great fund to consider. However, if you have a shorter time horizon or are uncomfortable with the potential of a bumpier ride, you will want to look elsewhere.
Fidelity Small Cap America Fund
| Fund Company | Fidelity Investments Canada |
| Fund Type | U.S. Small / Mid Cap Equity |
| Rating | A |
| Style | Blend |
| Risk Level | Medium High |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Steve MacMillan since May 2011 |
| MER | 2.35% |
| Code | FID 261 – Front End Units FID 561 – DSC Units |
| Minimum Investment | $500 |
Analysis: Investors have been rewarded handsomely since Steve MacMillan took over the management duties of this fund in May 2011. Since taking over, the fund has gained 70%, with more than half of that rise coming in 2013. Year to date, the fund is up 41%, which has left the benchmark and competition in the dust.
To do this, he runs a benchmark agnostic, concentrated portfolio of around 40 well managed companies that have good franchises and dominate their markets. The stock selection process is a bottom up one that relies heavily on Fidelity’s extensive research team to help identify investment ideas. Once a company is selected as a buy candidate, he meets with the management to confirm the fundamental findings. He will look to be patient and will generally take a 3 to 5 year investment view. Based on this, it is expected that portfolio turnover will be lower than 50%.
As of June 30, consumer discretionary, industrials and healthcare were the key sectors, which combined make up nearly 70% of the fund. From a sector point of view, this positioning will make it a nice compliment to a Canadian equity fund, which tend to be very light on those sectors.
Costs are reasonable, with an MER that is just below the category average.
While recent returns have been stellar, the absolute level of return is not sustainable going forward. I expect that we will see a period of more modest returns going forward. I would also expect to see the volatility of the fund start to creep upward as we move forward from here. Still, for investors who are looking for exposure to U.S. small caps, it is my opinion that this fund is a great way to do just that. I expect it to deliver above average returns with below average risk.
TD Health Sciences Fund
| Fund Company | TD Asset Management Inc. |
| Fund Type | Healthcare Equity |
| Rating | A |
| Style | Growth |
| Risk Level | Medium High |
| Load Status | No Load / Optional |
| RRSP/RRIF Suitability | Fair |
| TFSA Suitability | Fair |
| Manager | Kris Jenner since January 2000 |
| MER | 2.83% |
| Code | TDB 976 – No Load Units TDB 320 – Front End Units TDB 350 – DSC Units |
| Minimum Investment | $500 |
Analysis: Since mid 2010 healthcare stocks have been on quite a tear, with the Dow Jones Global Health Care Index gaining nearly 20% a year for the past three years. Part of the reason for this has been that the sector has a number of stable businesses that generate strong free cash flows, pay above average dividends, and have an earnings stream that is not tied to the global economy. Also, healthcare is generally considered a more defensive sector, and given many investors’ preference to play defense, the sector has become quite popular.
This has been one of my favourites. It invests in companies that are involved in the research, development, production, or distribution of products or services related to health care, medicine, or the life sciences. The manager tends to focus in the U.S. where nearly 85% of the fund is invested.
Volatility has been in line with the category average. Performance has been strong posting first quartile performance in all time periods, and handily outpacing the Dow Jones Global Health Care Index. It has also done a great job in protecting investors’ money. Historically, when the healthcare sector has lost money, this fund has lost much less, while managing to outperform when markets are rallying.
Another reason I like to have some healthcare exposure in a portfolio is that is has exhibited a relatively low level of correlation to the traditional asset classes. This will allow it to provide some reasonably compelling diversification benefits when included in a well-diversified portfolio. The biggest drawback to this fund is its cost, with an MER of 2.82%.
While this fund has done well, I would likely still favour the CI Global Health Sciences Fund. It has delivered stronger returns on both an absolute and risk adjusted basis, and carries a lower MER.